Robert Shiller is the Sterling Professor of Economics at Yale University. He developed a cyclically adjusted price-earnings ratio, called the CAPE ratio. We spoke recently about his research on stock asset valuations and market bubbles.
Charles Rotblut (CR): Can you explain what your CAPE ratio is and what it measures?
Robert Shiller (RS): The basic idea is that you need some measure of value relative to fundamentals. You can’t just look at price per share, which doesn’t tell you how something is over- or undervalued, but price relative to something. It seems to me that earnings is the natural candidate to compare price with. But the problem with earnings as it is used is that people tend to use lagging one-year earnings or projected earnings for the next year. One year is just too short of a time period because earnings are volatile and they jump around. In particular, the business cycle affects earnings. When we are in a recession, earnings tend to be low, for instance. So, I don’t think we should overreact to short-term fluctuations in earnings.
CAPE is called cyclically adjusted price-earnings ratio, and it is cyclically adjusted in the sense that we average the earnings over a longer interval of time. I have been using 10 years, which seems like a very long time for most finance people. People tend to think that something that happened 10 years ago is just so long ago that it is irrelevant. But, the conservative strategy argues that, no, it is not irrelevant and that companies last a long time. In order to really get a sense of their value, you have to look at a 10-year history and that is what I have been doing. I work with a former student, who is now a Harvard professor, John Campbell. We found that real price divided by 10-year average of earnings does actually help predict the stock market.
The stock market is somewhat predictable, using data all the way back to 1881. It has held up for a long period of time. The CAPE ratio does not predict what is going to happen next year very well. It is for long-term investors. It predicts what will happen over the next five or 10 years. In other words, when prices are high relative to 10-year average earnings, then that suggests that prices will come down, but you don’t know exactly when. You might have to wait five years or 10 years for them to come down. For patient, long-term investors, I think it makes sense to follow CAPE as an indicator of value.
CR: What is the CAPE right now?
CR: What should a long-term investor looking at the number do? Should they hold off on stocks or lighten up on their allocations? What would you suggest?
RS: You have to compare the alternatives. The problems now are that the main alternatives are not very good either. Long-term bond yields are near record lows, short-term interest rates are just about zero and the Treasury Inflation-Protected Securitiesare actually paying a negative yield out 10 or 15 years, so the alternatives are not very good. Taking that into account, the stock market doesn’t look so bad. I’m thinking that people should have something in stocks. You have to put your money somewhere, so although the CAPE ratio is high, it is not super high. In the year 2000, it was twice as high as it is now; I thought that was a bad signal, and I was right about that. We aren’t getting such a bad signal now from CAPE, so I think it is still important to put something in the market.
CR: If we were in a more normal situation for interest rates and bonds looked more attractive for investors, should investors put less in stocks or pull out of stocks until the ratio goes down? Using the year 2000 as an example, what should an investor have done at that point?
RS: In 2000, that’s when my first edition of “Irrational Exuberance” (Princeton University Press) came out, I expressed strong worries about the stock market. So the smart thing to do would have been to pull out completely or almost completely in 2000. In fact, more aggressive investors may have shorted the market. Shorting the market is a more aggressive policy that most people won’t do.
The question today is whether you want to short the bond market. And in a sense, I think you do want to short it. One thing is to buy a house and get a mortgage. Mortgage rates are so low now, so borrowing to buy a house is like shorting the bond market.
We live in a very unusual financial world right now. I find it so strange that the TIPS (Treasury Inflation-Protected Securities) yield is negative because that means that long term, 10 years, you can’t make a riskless return at all in real (inflation-adjusted) terms. Nothing. Less than nothing. If you invest your money, and you want it to be riskless, you are guaranteed that you will lose money. Guaranteed. But then it becomes a problem of preservation. There isn’t any safe way to store value and make money. If it is safe, it is losing money. If it is safe in real terms, it is losing money. And that’s just the world we live in now.
CR: What do you think drives stocks higher? In “Irrational Exuberance,” you talk about how people think it has to do with earnings or economic growth, but you say there is not an exact correlation.
RS: Well, when you talk about aggregate earnings, they are driven by irrational exuberance as well. It is driven by people’s spending on the products that companies make. I show a plot of corporate earnings through history and a plot of stock prices and they do seem to match up somewhat [see Figure 2]. When earnings are growing, stock prices go up. So you might think that earnings are really driving the market, and in some sense they are. But in another sense, it is feeding back because the market is driving earnings. When the market goes up, people spend more because they feel richer and are more optimistic, so earnings go up. So it is feedback both ways between stock prices and earnings. It is not that earnings are just driving things; they’re not exogenous. It’s part of a feedback between stock prices and earnings.
CR: When they’re analyzing the market, should investors look at a variety of indicators and piece together a story versus try to decide on one data point?
RS: It depends on your interests. But I think it’s reasonable for most people to conclude that they are not going to put enough time into this, especially to try to figure out the large-cap stocks that everyone is trading in because there are professional analysts following them and there are a lot of smart people you’re competing against. So I think it’s quite reasonable for someone to delegate authority by either getting an adviser who does it for them or simply diversifying broadly. The very simple way to diversify broadly is to invest in a market index. But those who are interested in thinking about investing can get somewhat of an edge. It’s not a huge edge, not as big as you might wish, but it is enough to be worthwhile if you enjoy doing this kind of thing.